Educational Articles

Stock Screen: High Returns Earned on Equity - October 13, 2011

Kevin Downing
| October 13, 2011

When an investor buys shares in a company, he or she is buying a portion of that enterprise. In fact, the whole idea behind investing in stocks is that the management team of a selected company can make better use of an investor’s resources than the investor can, and, thus, earn a return for the investor in the form of distributions (normally dividends) and/or a higher stock price. It can be difficult, however, to get a clear picture of how well a company makes use of the resources provided to it by shareholders.

One quick way to cut through the large number of investments available is to review returns on equity. Value Line calculates this number, which appears in the Statistical Array on every research report, by dividing net profits by shareholders’ equity (equity, or net worth, itself, is equal to the difference between total assets and total liabilities). The general idea of the measure is to see how much a company earns on the money it has been given by equity (including preferred equity) investors. Companies with high scores are, presumably, better wards of capital

To create our list, we first screened for companies ranked 3 (Average), or higher, for Timeliness (i.e. relative price performance in the year ahead), one of Value Line’s proprietary measures. Next, we computed the average percentage earned on shareholders’ equity by each company over the last five years for which we have actual data, and set a floor for the measure at 28.5%.

Investors should be aware that the use of a five-year average tends to favor consistent earners of substantial returns on common equity over companies that have recently experienced recoveries.

Return on equity is best used as a starting point and a comparison tool. Some industries will never show up on a screen of this nature, others will have many representatives. Thus, comparisons between companies in the same industry will provide more insight than comparisons between companies in different industries. Below are some highlights from our screen:

Joy Global, Inc.

Joy Global (JOY) is a leading manufacturer and servicer of high productivity mining equipment for the extraction of minerals from the earth. Its equipment is used in major mining regions throughout the world to mine coal, copper, iron ore, oil sands, and other minerals. The company’s two business segments cover underground and surface mining devices. Sales of original equipment for the mining industry accounted for 40% of 2010 revenues. The remainder was supplied by aftermarket sales, which include revenues from maintenance and repair services, diagnostic analysis, fabrication, mining equipment and electric motor rebuilds, equipment erection services, training, and sales of replacement parts. In 2010, the company recorded a return on equity of 34%.

Shares of Joy Global have taken a beating over the past few months, as investors have been increasingly concerned with the effect that the global economy may have on mining activity, and, thus, the company’s profits. Recently, some better economic news and progress toward a resolution to Europe’s debt crisis have allowed the shares to regain some of their lost ground.

Furthermore, management recently made encouraging comments about its order backlog being near record levels. It also said that if a prolonged downturn does occur, it will be better insulated than during the 2008-2009 recession considering the number of contracts and down payments it has in place, as well as the stronger general financial condition of its clients. Value Line analyst David Reimer believes that sales to China and India will remain healthy. Too, the recent $1.1 billion acquisition of LeTourneau Technologies is already a contributor to the top and bottom lines. The pending acquisition of International Mining Machinery may well be approved by Chinese regulators during the fourth quarter, and if it is, we expect the bottom line to benefit significantly over the next two years. Given that the shares are still trading below their historical price to earnings multiple range, we think there is still worthwhile near-term recovery potential.

The company’s stock has proven quite volatile over the past six months. This can be partly explained by the semiconductor industry’s changing volume expectations for the coming year. Indeed, earlier in 2011, when prospects were brighter, KLIC’s stock jumped nearly 40% after management guided above analyst’s expectations. Since then, it has given back most of that gain as many OEM’s have curbed expectations for near-term integrated circuit demand.

Although the potential for slowing economic growth presents a meaningful risk to the company’s near-term performance, we think KLIC is somewhat more insulated from a downturn than other semi players due to its dominant position in copper ball bonders (which connect chips to other components of an electronic device). Copper bonders have increased in demand due to the relatively high price of gold, an alternative metal used in wire bonding. Historically, gold has been the bonder of choice due to its higher productivity, but Kulicke & Soffa has developed a cheaper copper solution with comparable performance. We expect this, along with effective cost control and a streamlined manufacturing process, to keep the company’s return on equity above 20% for the foreseeable future. Note, this stock receives low scores for Safety and Stock Price Stability, so conservative investors should probably look elsewhere.

Health Management Associates

Health Management Associates (HMA) operates general acute care hospitals and other health care facilities in non-urban communities. As of December 31, 2010, it operated 59 hospitals with a total of 8,864 licensed beds in the following states: AL, AR, FL, GA, KY, MS, MO, NC, OK, PA, SC, TN, TX, WA, and WV. Part of the company’s strategy is to acquire underperforming non-urban acute care hospitals that are available at a reasonable price and align with its business model.

Recent weakness in HMA’s stock price reflects the issuance of two subpoenas against the company. The U.S. Dept. of Health and Human Services, Office of Inspector General has requested information about physician referrals in order to ensure the company is not recommending patients stay longer than necessary. Value Line analyst Eric Antonson does not suspect foul play, but admits that any evidence that the company acted inappropriately will likely be met with reduced interest in the shares.

Meanwhile the company is making acquisitions to offset the effects that weak unemployment have been having on volumes. We think this strategy, along with the potential for an improved job market, will allow the company to keep its return on equity north of 24% for the next two years.

To see the results of our screen, limited to those stocks that carry Above-Average scores for Timeliness, subscribers can click here. As always, subscribers should carefully review the analyses in Ratings & Reports before committing funds to any particular equity.

At the time of this article's writing, the author did not have positions in any of the companies mentioned.